Risk, Resilience, And Rebalancing In Global Value Chains

In briefRisk, resilience, and rebalancingin global value chainsIntricate supplier networks that spanthe globe can deliver with greatefficiency, but they may containhidden vulnerabilities. Even beforethe COVID‑19 pandemic, a multitudeof events in recent years temporarilydisrupted production at manycompanies. Focusing on value chainsthat produce manufactured goods,this research explores their exposureto shocks, their vulnerabilities, andtheir expected financial losses. Wealso assess prospects for value chainsto change their physical footprintin response to risk and evaluatestrategies to minimize the growing costof disruptions.Shocks that affect global productionare growing more frequent andmore severe. Companies face a rangeof hazards, from natural disastersto geopolitical uncertainties andcyberattacks on their digital systems.Global flows and networks offermore “surface area” for shocks topenetrate and damage to spread.Disruptions lasting a month or longernow occur every 3.7 years on average,and the financial toll associated withthe most extreme events has beenclimbing. Shocks can be distinguishedby whether they can be anticipated,how frequently they occur, the breadthof impact across industries andgeographies, and the magnitude ofimpact on supply and demand.Value chains are exposed todifferent types of shocks basedon their geographic footprint,factors of production, and othervariables. Those with the highest tradeintensity and export concentrationin a few countries are more exposedthan others. They include some ofthe highest-value and most soughtafter industries, such as communicationequipment, computers and electronics,and semiconductors and components.Many labor-intensive value chains,such as apparel, are highly exposed topandemics, heat stress, and flood risk.In contrast, food and beverage andfabricated metals have lower averageexposure to shocks because theyare among the least traded and mostregionally oriented value chains.Operational choices can heightenor lessen vulnerability to shocks.Practices such as just-in-timeproduction, sourcing from a singlesupplier, and relying on customizedinputs with few substitutes amplifythe disruption of external shocks andlengthen companies’ recovery times.Geographic concentration in supplynetworks can also be a vulnerability.Globally, we find 180 traded products(worth 134 billion in 2018) for whicha single country accounts for the vastmajority of exports.Value chain disruptions causesubstantial financial losses. Adjustedfor the probability and frequency ofdisruptions, companies can expect tolose more than 40 percent of a year’sprofits every decade on average. Buta single severe event that disruptsproduction for 100 days—somethingthat happens every five to sevenyears on average—could erase almosta year’s earnings in some industries.Disruptions are costly to societies,too: after disasters claim lives anddamage communities, productionshutdowns can cause job losses andgoods shortages. Resilience measurescould more than pay off for companies,workers, and broader societies overthe long term.The interconnected nature of valuechains limits the economic case formaking large-scale changes in theirphysical location. Value chains oftenspan thousands of companies, and theirconfigurations reflect specialization,access to consumer markets aroundthe world, long-standing relationships,and economies of scale. Primarilylabor-intensive value chains (such asapparel and furniture) have a strongeconomic rationale for shifting to newlocations. Noneconomic pressuresmay prompt movement in others, suchas pharmaceuticals. Consideringboth industry economics and nationalpolicy priorities, we estimate that 16to 26 percent of global goods exports,worth 2.9 trillion to 4.6 trillion, couldconceivably move to new countriesover the next five years if companiesrestructure their supplier networks.Building supply chain resiliencecan take many forms beyondrelocating production. This includesstrengthening risk managementcapabilities and improvingtransparency; building redundancyin supplier and transportationnetworks; holding more inventory;reducing product complexity; creatingthe capacity to flex production acrosssites; and improving the financial andoperational capacity to respond toshocks and recover quickly from them.Becoming more resilient does not haveto mean sacrificing efficiency. Ourresearch highlights the many optionsfor strengthening value chain resilience,including opportunities arising fromnew technologies. Where companiescannot directly prevent shocks,they can still position themselves toreduce the cost of disruption andthe time it takes to recover. Companieshave an opportunity to emergefrom the current crisis more agileand innovative.

Risk, resilience, and rebalancingin global value chainsSupply chain shocks are becoming more frequent and severeA disruption ofthis length . . .Acute climatechangeMacroeconomic/financial crisesTradedisputePandemic1–2 weeks. . . occurs atthis interval2.0 years2.8 years2–4 weeks1–2 monthsChronicclimate changeCyberattackTerrorismSupplierbankruptcy3.7 years4.9 years2 monthsSome value chains are more exposed to shocks than othersBased on geographic footprint, factors of production, and other characteristicsMedicaldevicesFood onductorsAerospaceComputersandelectronicsLess entMore exposedSupply chain disruptions are costlyShock exposureVulnerabilityUnexpected events thatcause disruptionFragility in key areasForce majeureSupplier network structureMacropoliticalMalicious actorsIdiosyncraticDemand planning and inventoryTransportation and logisticsBalance sheetValue chain riskCompanies canexpect to lose42%of one year's EBITDAevery decade.Investing to minimizethese losses can payoff over the long termProduct and portfolio complexityCompanies can build resilience by improving supply chain managementand transparency, minimizing exposure to shocks,and building their capacity to respond

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Executive summaryIn recent decades, value chains have grown in length and complexity as companies expandedaround the world in pursuit of margin improvements. Since 2000, the value of intermediategoods traded globally has tripled to more than 10 trillion annually. Businesses thatsuccessfully implemented a lean, global model of manufacturing achieved improvements inindicators such as inventory levels, on-time-in-full deliveries, and shorter lead times.However, these operating model choices sometimes led to unintended consequences ifthey were not calibrated to risk exposure. Intricate production networks were designed forefficiency, cost, and proximity to markets but not necessarily for transparency or resilience.Now they are operating in a world where disruptions are regular occurrences. Averagingacross industries, companies can now expect supply chain disruptions lasting a month orlonger to occur every 3.7 years, and the most severe events take a major financial toll.This report explores the rebalancing act facing many companies in goods-producing valuechains as they seek to get a handle on risk. Our focus is not on ongoing business challengessuch as shifting customer demand and suppliers failing to deliver, nor on ongoing trendssuch as digitization and automation. Instead, we consider risks that manifest from exposureto the most profound shocks, such as financial crises, terrorism, extreme weather, and,yes, pandemics.The risk facing any particular industry value chain reflects its level of exposure to differenttypes of shocks, plus the underlying vulnerabilities of a particular company or in the valuechain as a whole. We therefore examine the growing frequency and severity of a range ofshocks, assess how different value chains are exposed, and examine the factors in operationsand supply chains that can magnify disruption and losses. Adjusted for the probability andfrequency of disruptions, companies can expect to lose more than 40 percent of a year’sprofits every decade, based on a model informed by the financials of 325 companies across13 industries. However, a single severe shock causing a 100-day disruption could wipe outan entire year’s earnings or more in some industries—and events of this magnitude can anddo occur.Recent trade tensions and now the COVID‑19 pandemic have led to speculation thatcompanies could shift to more domestic production and sourcing. We examined the feasibilityof movement based on industry economics as well as the possibility that governments mightact to bolster domestic production of some goods they deem essential or strategic froma national security or competitiveness perspective. All told, we estimate that production ofsome 16 to 26 percent of global trade, worth 2.9 trillion to 4.6 trillion, could move acrossborders in the medium term. This could involve some combination of reverting to domesticproduction, nearshoring, and shifting to different offshore locations.Moving the physical footprint of production is only one of many options for building resilience,which we broadly define as the ability to resist, withstand, and recover from shocks. In fact,technology is challenging old assumptions that resilience can be purchased only at the costof efficiency. The latest advances offer new solutions for running scenarios, monitoringmany layers of supplier networks, accelerating response times, and even changingthe economics of production. Some manufacturing companies will no doubt use these toolsand devise other strategies to come out on the other side of the pandemic as more agile andinnovative organizations.Risk, resilience, and rebalancing in global value chains1

With shocks growing more frequent and severe, industry value chainsvary in their level of exposure80%of global trade involves nationswith declining political stabilityscores from the World BankThe COVID pandemic has delivered the biggest and broadest value chain shock in recentmemory (see Box E1, “Globalization before and after COVID‑19”). But it is actually the latestin a long series of disruptions. In 2011, for instance, a major earthquake and tsunami in Japanshut down factories that produce electronic components for cars, halting assembly linesworldwide. The disaster also knocked out the world’s top producer of advanced silicon wafers,on which semiconductor companies rely. Just a few months later, flooding swamped factoriesin Thailand that produced roughly a quarter of the world’s hard drives, leaving the makers ofpersonal computers scrambling. In 2017, Hurricane Harvey, a Category 4 storm, smashedinto Texas and Louisiana. It disrupted some of the largest US oil refineries and petrochemicalplants, creating shortages of key plastics and resins for a range of industries.This is more than just a run of bad luck. Changes in the environment and in the global economyare increasing the frequency and magnitude of shocks. Forty weather disasters in 2019caused damages exceeding 1 billion each—and in recent years, the economic toll causedby the most extreme events has been escalating.1 As a new multipolar world takes shape,we are seeing more trade disputes, higher tariffs, and broader geopolitical uncertainty.The share of global trade conducted with countries ranked in the bottom half of the world forpolitical stability, as assessed by the World Bank, rose from 16 percent in 2000 to 29 percentin 2018. Just as telling, almost 80 percent of trade involves nations with declining politicalstability scores.2 Increased reliance on digital systems increases exposure to a wide varietyof cyberattacks; the number of new ransomware variations alone doubled from 2018 to2019. 3 Interconnected supply chains and global flows of data, finance, and people offermore “surface area” for risk to penetrate, and ripple effects can travel across these networkstructures rapidly.To understand the full range of potential disruptions and avoid the trap of “fighting the lastwar,” companies must look beyond the latest disaster. Not all shocks are created equal.Some pass quickly, while others can sideline multiple industry players for weeks or evenmonths. Business leaders often characterize shocks in terms of their source. These mayinclude force majeure events, such as natural disasters; macropolitical shocks, such asfinancial crises; the work of malicious actors, such as theft; and idiosyncratic shocks, such asunplanned outages. But characteristics beyond the source of a shock determine its scopeand the severity of its impact on production and global value chains.Exhibit E1 classifies different types of shocks based on their impact, lead time, and frequencyof occurrence. In a few cases, we show hypothetical shocks like a global military conflict ora systemic cyberattack that would dwarf the most severe shocks experienced to date. Whilethese may be only remote possibilities, these scenarios are in fact studied and planned forby governments and security experts. The impact of a shock can be influenced by how longit lasts, the ripple effects it has across geographies and industries, and whether a shock hitsthe supply side alone or also hits demand.1232Eye of the Storm, “Earth’s 40 billion-dollar weather disasters of 2019,” Scientific American blog entry by Jeff Masters,January 22, 2020; and Matteo Coronese et al., “Evidence for sharp increase in the economic damages of extreme naturaldisasters,” Proceedings of the National Academy of Sciences, October 2019, Volume 116, Number 43.World Bank, Worldwide Governance Indicators 2018 (political stability and absence of violence/terrorism).Anthony Spadafora, “Ransomware mutations double in 2019,” TechRadar, August 20, 2019.McKinsey Global Institute

Box E1Globalization before and after COVID‑19Trade flows ultimately reflect wherecountless companies decide to investand make, buy, or sell things—as well asthe intermediaries and arrangementsthey set up to do this as productively aspossible. Trade in manufactured goodssoared in the 1990s and early 2000s,propelled by China’s entry into the WTOand the search by multinationalcompanies for lower-cost inputs andwages. Digital communication loweredtransaction costs, enabling companiesto do business with suppliers andcustomers halfway around the world.Overall, goods trade grew at more thantwice the rate of global GDP growthover this period. MGI’s analysis findsthat, over a decade, all types of flowsacting together have raised world GDPby 10.1 percent over what would haveresulted in a world without any crossborder flows.1The 2008 financial crisis interruptedthose trends, causing global trade flowsto plummet. When the global economyrecovered, they stabilized but did notreturn to their past growth trajectory.As described in MGI’s 2019 research,this was largely because China andother emerging economies reachedthe next stage of their development.2They initially participated in global valuechains as assemblers of final goods, butincreasingly became the world’s majorengine of demand growth and startedto develop more extensive domesticsupply chains, decreasing their relianceon imported inputs. As a result ofthese developments, a smaller share ofthe goods produced worldwide is soldacross borders.The latest wave of manufacturingtechnologies also meant shifting1234dynamics within global value chains;only 13 percent of overall goods tradein 2018 involved exports from a lowwage country to a high-wage country. 3In all except the most labor-intensiveindustries, companies started to baselocation decisions on other factors,including access to highly skilled talent,supplier ecosystems, infrastructure,business environment, and IPprotection. Another long-term evolutionis the regionalization of productionnetworks. Long-haul trade betweenregions took off in the 1990s andearly 2000s as global supply chainslengthened. But recently, trade hasbecome more regionally concentrated,particularly within Europe and Asia–Pacific. This has enabled companiesto serve major markets quickly andresponsively. With rising complexity ofglobal production, as well as concernsover trade disputes pre-COVID, supplychain risk and resilience have also beenemerging as increasing considerationson companies’ radars.In the wake of the pandemic, travel,tourism, and migration may take yearsto return to previous levels. Trade ingoods has taken a substantial hit,falling by 13 percent in the first threemonths of 2020. But much of this isdue to a sharp contraction in demandthat should eventually reverse whenthe virus is contained and economiesrecover. In the meantime, cross-borderdigital flows continue to take on greaterimportance as the connective tissue ofthe global economy.COVID‑19 seems to be acceleratingsome of the trends that were alreadymanifesting within the world’s valuechains, including the regionalizationof trade and production networks,the growing role of digitization, andthe focus on proximity to consumers. 4The increasing use of automationtechnologies in manufacturing islessening the importance of low laborcosts—and more automated plantscould be more resilient in the face ofpandemics and heat waves (althoughpotentially more vulnerable tocyberattacks).Companies and governments alikeare reassessing the way goods flowacross borders, and they may stillmake targeted adjustments to shoreup the places where they see fragility.But the pandemic has not reshapedthe world’s production networks indramatic ways thus far. After all, globalvalue chains took on their currentstructures over many years, reflectingeconomic logic, hundreds of billionsof dollars’ worth of investment, andlong-standing supplier relationships.A major multinational’s suppliernetwork may encompass thousandsof companies, each with its ownspecialized contribution.Tariffs and tax policies are oftenused by governments to try toshift where things are made. Butmany considerations go into wherecompanies place manufacturing andwhere they source. These includegrowth in consumer demand, speedto market, changing labor andinput costs, new technologies, andthe availability of specialized workforceskills. Risk and resilience now featureprominently on that list as well—andeven though the costs of risk aregrowing, they do not imply the end ofglobalization’s opportunities.Digital globalization: The new era of global flows, McKinsey Global Institute, March 2016.All of the structural trends described here are explored in Globalization in transition: The future of trade and value chains, McKinsey Global Institute, January 2019.Defined as exports from a country where GDP per capita is one-fifth that of the importing country or less. Even if we vary the ratio of GDP per capita of the exporterand importer, we continue to see a decline in labor-cost arbitrage in value chains producing labor-intensive goods.See Globalization in transition: The future of trade and value chains, McKinsey Global Institute, January 2019.Risk, resilience, and rebalancing in global value chains3

Exhibit E1Disruptions vary based on their severity, frequency, and lead time—and they occurwith regularity.Magnitude and ability to entHas not (yet)occurred at scale1Foreseeable catastrophesTrillions100s ofbillionsMeteoroid strikeSolar stormExtreme terrorism(eg, dirty bomb)ExtremepandemicSystemic cyberattackMajor ncratic(eg, supplierbankruptcy)Trade earsAcute climatologicalevent (heat wave)2Counterfeit2 monthsUnanticipatedbusiness disruptionsNonePandemicGlobalmilitaryconflictBased on expert interviews, n 35Financial crisisAcute climatologicalevent (hurricane)2Terrorism10s ofbillionsMillionsMagnitude of estimated cost of shock, 10s oftrillionsUnanticipated catastrophesExpected frequency ofa disruption, by duration, years4.9yearsForeseeable disruptionsDaysWeeksMonths or moreAbility to anticipate (lead time)1. Shocks that have not occurred either at scale (eg, extreme terrorism, systemic cyberattack, solar storm) or in modern times (eg, meteoroid strike,supervolcano).2. Based on experience to date; frequency and/or severity of events could increase over time.Source: McKinsey Global Institute analysisThis analysis reveals four broad categories of shocks. Catastrophes

Michael Chui, Susan Lund, Anu Madgavkar, Jan Mischke, Sree Ramaswamy, Jaana Remes, Jeongmin Seong, and Tilman Tacke are MGI partners. Mekala Krishnan is an MGI senior fellow, and Sundiatu Dixon-Fyle is a visiting senior fellow. Project teams are led by the MGI partners and a group of senior